Are Stock Buybacks Always Good?

While buyback equity indexes have easily outperformed major stock benchmarks like the Dow Industrials, not all of that money is always well spent.

As of late, companies reinvesting capital to buy their own stock has been on the rise. But is it always a win-win for shareholders?

Last year, S&P 500 (NYSEARCA:SPY) companies made $398.9 billion in share repurchases and this year, buyback programs are running nearly double, according to some estimates.

Corporations reduce their outstanding share count via stock buybacks. Often, buybacks will occur over a period of years and management will usually issue a statement like, "Investing in our own stock is a good investment." More on that in a minute.

Which industry sectors have the highest buyback activity?

Factset reports:

The information technology (NYSEARCA:XLK) and health care (NYSEARCA:XLV) sectors spent the most on quarterly repurchases ($19.8 billion and $14.4 billion, respectively) in Q4 2012. However, of the sectors that averaged $2 billion or more in quarterly share repurchases since 2005, the industrials (NYSEARCA:XLI) sector showed the largest sequential and year-over-year growth (30.6% and 59.4%) in dollar-value buybacks.

The peak in corporate share buybacks was reached back in 2007, when companies bought $589.1 billion worth of stock.

"For 2013, S&P Dow Jones Indices anticipates that companies will continue to protect their earnings by buying back the number of shares necessary to prevent earnings dilution – something not difficult to do given record levels of cash on hand," said Howard Silverblatt, Senior Index Analyst at S&P Dow Jones Indices.

While buyback equity indexes have easily outperformed major stock benchmarks like the Dow Industrials (NYSEARCA:DIA), not all of that money is always well spent.

From 2004 to 2011, around $2.7 trillion was spent by S&P 500 companies on share buybacks, according to a Credit Suisse study. The report concluded, "Using our Stock Buyback Scorecard we find only 180 companies that were able to generate a return above a 7% cost of equity and just 98 companies that beat simple dollar cost averaging. As a result it looks like most of the buybacks by the S&P 500 (INDEXSP:.INX) over the past eight years have not yet added much value for remaining shareholders."

With stock prices up sharply since 2009, share buybacks at any price have looked smart. However, once stock prices correct, we will find out which companies went overboard with buybacks.

They tempt management to pad their compensation by massaging EPS numbers, which are in turn linked to pay.

Corporate managers buying company shares at the wrong price is always a risk.

Use of leverage (borrowing) by companies to for stock buybacks also increases risk.

Undoubtedly, companies that consistently buy their own stock at low prices help shareholders to get ahead. But too few management teams have been able to do that. Berkshire Hathaway's (NYSE:BRK-A) Warren Buffett is a rare example. Over the decades, Buffett has preferred to use corporate cash for buybacks versus paying dividends.

How can investors measure the effectiveness of buybacks?

One way to measure whether companies are making prudent buybacks is to compare the valuations at which they pay for their own shares to the stock's historical median valuation.

Two ETFs focused on the share repurchase strategy are the PowerShares Buyback Achievers (NYSEARCA:PKW) and the TrimTabs Float Shrink ETF (NYSEARCA:TTFS). The latter screens out companies that dilute shares or that overleverage to buy their own shares.

Editor's note: This story by Ron DeLegge originally appeared on ETFguide.com.